Regulation W – The Operational Challenges

Regulation W was enacted by the Federal Reserve Board, effective April 1, 2003, as a rule that would implement, interpret and provide consistent application of sections 23A and 23B of the Federal Reserve Act. The regulation places quantitative and qualitative limits on certain transactions between a member bank and its affiliate; its main purpose is to protect the bank from financial losses as a result of such transactions and to limit the ability of the bank to transfer the subsidy gained from access to federal deposit insurance to its affiliates.

Regulation W: Key Dates

The foundation of Regulation W was formed upon the enactment of Section 23A of the Federal Reserve Act in 1933. Section 23B was later added with additional restrictions and qualifications for transactions. More recently, Section 608 of the Dodd-Frank Act provided a number of significant changes in Section 23A. The most noteworthy change is the inclusion of derivatives and securities lending and borrowing transactions that create credit exposure, including repurchase agreements and swaps, as covered transactions. Formal guidance from the Federal Reserve Board on changes to Regulation W as a result of Section 608 has not yet been issued.

Figure 1 below shows the key dates and events in the evolution of Regulation W:

Regulation W: Key Definitions and Provisions

The table below highlights key definitions and provisions of each section:

Regulation W Key Definitions & Provisions

Category

Description

Definitions

Covered Affiliate Definition

Section 23A provides a definition of what is considered a covered affiliate of the bank.[i] Examples of covered affiliates include:

·Company that controls the bank

·Investment company for which bank serves as an adviser

·Merchant banking investment in which bank controls >15% of equity

·Generally, any company with relationship to the bank that transactions may have negative effect on the bank

Covered Transaction Definition

Section 23A provides a definition of a covered transaction, including exemptions. Examples of covered transactions include:

·Extension of credit to a covered affiliate

·Purchase of an asset from a covered affiliate

·Purchase of a security issued by a covered affiliate

Certain transactions with affiliates are exempted, particularly those that do not expose the bank to excessive risk or misuse of the Fed subsidy.[ii]

Section 23A

Provisions

Qualitative Standards

Covered transactions must be on terms and conditions that are consistent with safe and sound banking practices. Banks are prohibited from purchasing a low-quality asset from a covered affiliate.

Quantitative Limits

Section 23A restricts the total amount of covered transactions the bank can conduct with any one affiliate, as well as all affiliates combined:

·Covered transactions between the bank and any one affiliate is limited to 10% of its capital stock and surplus

·Covered transactions between the bank and all its affiliates is limited to 20% of its capital stock and surplus

Section 23 A requires that covered transactions must be fully collateralized at all times by required collateral about. The market value of collateral required differs for different asset classes[iii].

Attribution Rule

To prevent banks from using third-party intermediaries to evade restrictions, Section 23A institutes the attribution rule, in which any transaction between the bank and counterparty will be considered a transaction between the bank and an affiliate if the proceeds of the transaction are used for the benefit of the affiliate. [iv],[v]

Section 23B

Provisions

Market Terms

Covered transactions must be at market terms and on an arm’s length basis. If comparable transactions do not exist, then the transaction must be on terms that would be offered to non-affiliates in good faith.

Asset Purchase Restrictions

Section 23B further excludes certain types of asset purchases:

·Purchases of a security or other assets from a covered affiliate as a fiduciary are prohibited

·Purchases of a security underwritten by an affiliate are prohibited

The Operational Challenges:

The large number of restrictions and limitations put forth in Regulation W and Sections 23A and 23B along with anticipated changes due to Dodd Frank present a diverse range of current and potentially new business and operational challenges for banks. In this piece, we focus on the current operational challenges. While the severity of these operational difficulties will vary depending on the infrastructure and processes already in place, there are commonalities to be found across all banks subject to the Regulation.

Key Challenges:

Disparate Data Sources

Many businesses across a bank may be able to conduct covered transactions or participate in activities which cause an extension of credit from the bank to a covered affiliate. Given the expansive nature of this regulation, banks will need to look at various sources of data to extract critical information in investigating covered transactions. Most banks looking to properly monitor its processes and activities to prevent Regulation W breaches will likely face obstacles if its data sources are disparate and inconsistent.

Identification and Surveillance of Covered Transactions

Since the definition of a covered transaction is broad, banks should not limit its monitoring program to only loans or asset purchases from an affiliate. Activities such as payment of taxes on behalf of an affiliate and internal liquidity management that provides funding to an affiliate are considered covered transactions. Surveillance is therefore necessary for many non-lending functions, and not limited to trading desks and corporate banking groups.

Collateral Management

Covered transactions need to be collateralized, either on a transaction level or through a segregated, pledged account. This creates a need for banks to provide precise collateral management for covered transactions as well as tracking of the segregated account to ensure they fulfill the requirements of the regulation.

Affiliate List Update

Banks are required to keep a list of its affiliates. One challenge is keeping track of ownership levels of Merchant Banking Investments. As equity positions on these investments can change daily, their statues as an affiliate will change often. To deem all Merchant Banking Investment affiliates would create noise but not tracking these frequently increases the risk of a Regulation W breach.

Attribution Rule

The attribution rule can create a burden on banks to monitor lending and funds to third parties to ensure that they do not ultimately benefit an affiliate. This requires prudence not only on the part of the bank, but also on the counterparty to the initial transaction.

Cost Benefit of Preventive vs. Detective Controls

Attempting to detect covered transactions would require monitoring of all desks and business lines to be comprehensive but to do so this comes at a cost, both in efficiency as well as monetarily. Implementing preventive controls only in areas that are known to conduct covered transactions presents a potential risk that desks not systematically monitored could start conducting covered transactions that would go undetected.
Accenture’s Regulation W Solution Framework

In Accenture’s experience, banks will likely have to adopt a firm-wide compliance program articulated around the following five points in order to respond efficiently to the operational challenges posed by Regulation W.

Governance
A Regulation W solution can require oversight from a centralized group in the bank; most likely, this ownership will reside in the Compliance department. The governance group would coordinate and manage all efforts related to Regulation W adherence within the bank. The group will provide frequent reporting internally to highlight key risks and externally to demonstrate bank adherence to quantitative limits. Additionally, the group would be responsible for maintaining the bank’s policies with regards to Regulation W and ensure adoption of processes by all applicable stakeholder businesses in the bank.

Data Consolidation and Transaction Surveillance System
To automate detection of covered transactions and provide timely calculation of quantitative limits, various points of data could be needed from around the bank. Banks may rethink reference data or create additional databases to consolidate the necessary data. A surveillance system built in conjunction with data consolidation would help the bank monitor covered transaction activity to help ensure compliance with the 10%/20% capital requirements and collateral sufficiency.

Risk Assessment and Controls Infrastructure
Banks can undergo an assessment to identify areas with known covered transactions as well as areas that have high likelihood of conducting covered transactions. Controls and checks should subsequently be implemented in these areas to assess whether the transaction is allowed under the regulation and to determine if proper collateralization is in place.

Documented Processes and Procedures
As part of the controls infrastructure, a key action would be to document processes and procedures for all areas with potential for conducting covered transactions. Documentation can provide clarity and transparency in conforming to the regulation and promotes consistency across the bank. These processes and procedures should be updated on a frequent basis as businesses change. Processes and procedures should detail all transaction reviews, validations and approvals necessary to follow the regulation.

Training
Training for key personnel within the bank to equip them with knowledge of the regulation and its ramifications can provide the first line of defense against potential breaches. Training will need to be specific for each group so that it is relevant to the particular group and is refreshed and administered on a regular basis. Training can enforce accountability and ownership by all stakeholders.

Conclusion

Regulation W, through Sections 23A and 23B of the Federal Reserve Act, places various limitations on a bank’s activities with its affiliates. As the regulation becomes more scrutinized by regulators, banks must reassess their policies and infrastructure and take action on identified gaps. By utilizing Accenture’s framework and leveraging Accenture’s experience in risk management, finance and technology, banks can be well-positioned to address the regulation and its various obstacles.

For additional information on Accenture’s perspectives on this topic, please contact: Rahim Inoussa from the Risk Management Practice.

DISCLAIMER: This document is intended for general informational purposes only and does not take into account the reader’s specific circumstances, and may not reflect the most current developments. Accenture disclaims, to the fullest extent permitted by applicable law, any and all liability for the accuracy and completeness of the information in this document and for any acts or omissions made based on such information. Accenture does not provide legal, regulatory, audit, or tax advice. Readers are responsible for obtaining such advice from their own legal counsel or other licensed professionals.

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